Budget Planning: Materials

The electrical contractor (EC) is usually one of the first contractors to mobilize on a construction project to install temporary power and underground raceway systems. The EC also is one of the last to demobilize because of the need to connect equipment and systems other trades installed, trim out the electrical installation after contractors have competed their work, and commission installed power, communications and control systems. As a result, the EC can expect its performance on construction projects to take more than a year from contract execution to substantial completion, which introduces the risk of rising construction material and equipment prices during the performance period, making cost-consciousness a necessity.

The global economic slowdown and the resulting lackluster construction market have created stable electrical material and equipment prices and availability over the past couple years, so price escalation has not been a concern. However, it was not that many years ago when the construction industry was faced with rising prices and material and equipment shortages due to fierce competition for commodities—such as copper, aluminum, steel and petroleum—that are used to manufacture many electrical construction products. With signs of both the U.S. and global economies beginning to recover and expand, now is the time for ECs to start thinking about how to address potential price escalation on projects that it is currently bidding on or negotiating.

Where is the risk?

A variety of factors affect product price and availability. The EC’s supply chain is subject to global rivalry as firms compete for the acquisition of needed raw materials for product manufacturing. It also affects the delivery of the finished product to the job site. The construction industry players must compete with other industries that also use these same raw materials. In addition, government intervention in raw material, component part and finished product markets through import and export restrictions, tariffs and taxes, currency exchange rates, embargoes and trade restrictions, and other policies can affect electrical material and equipment prices and availability (e.g., the rare earth materials crisis affecting lighting manufacturing). Add the potential effect of foreign governments in transition, civil unrest and wars, natural disasters, strikes and lockouts, and other random events and the electrical contractor’s global supply chain can become very risky.

Impact of unexpected price increases

According to the “2010 NECA Financial Performance Report,” material costs represent about 38 percent of an inside EC’s direct construction costs. These materials range from bulk-purchase items such as conductors and raceway to highly specialized power, communications and control equipment and systems; they vary depending on the type of project and the EC’s scope of work. Prices are sensitive to fluctuations in their underlying commodity prices. Due to the significant portion of direct construction costs that material costs represent, even a small unexpected increase in construction material and equipment prices can reduce project profitability and have a resulting negative impact on both the EC’s net income and resulting return on owner’s equity (ROE) if price escalation risk is not managed.

Managing price escalation risk

Contracts for commercial, industrial and institutional (CII) facility construction, expansion and renovation are typically fixed-price agreements. Owners prefer fixed-price construction contracts because they know upfront with certainty what the project is going to cost, and this type of contract allows owners to cap their financial risk. Fixed-price construction contracts transfer the risk for material and equipment price increases to the EC if it is acting as a prime contractor or to the general contractor/construction manager (GC/CM). In the latter case, the GC/CM transfers the risk to the EC for its scope of work through a fixed-price subcontract.

Unfortunately for the EC, the times when material prices are increasing are also the periods when materials and equipment are in high demand and in short supply. As a result, suppliers do not have to accept the risk of guaranteeing a material and equipment price at the beginning of a project for delivery and subsequent payment by the EC sometime in the future. Instead, the EC’s suppliers cap their risk by limiting the time that their price quote is valid to a defined period such as 30 or 60 days or, during times of high price volatility, just a few days. The EC is caught in the middle when dealing with material and equipment price escalation and has limited options for dealing with this issue.

While limited, there are ways an EC can effectively manage price escalation risk without becoming a commodities trader or carrying a warehouse full of materials and equipment to hedge risk. Rather, the EC can use a strategy to capitalize on existing procurement skills and leverage the capabilities of its partners.

Early purchase strategy

If an EC believes there will be substantial price increases for particular materials and equipment during construction, it can purchase them early in the project, locking in the price and eliminating escalation risk. To be effective, the purchase would need to occur after the EC’s contract is executed and before the affected supplier’s quote expires. As a result, the EC will experience higher cash flows earlier in the project than it normally would. However, there are some drawbacks to this approach. Depending on the magnitude of early purchases, the skewed project cash flow could affect the EC’s cash position and line of credit. In addition, early purchases will impact project finance costs, including the EC’s internal cost of capital and economic profit. For this strategy to be effective, financial arrangements must be made to mitigate the effect of advance purchases.

The effect of early purchases on cash flow can be minimized by negotiating a larger-than-normal mobilization payment at the beginning of the project. In addition, the contract payment clause could be modified so that materials and equipment purchased in advance that meet contractual guarantees for delivery and storage could be included in monthly pay requests prior to installation. The modifications could be included as voluntary alternates in the EC’s bid that also includes a deduction for these payment concessions. That would be in lieu of the contingency amount included in the EC’s bid to address its price escalation risk. Meanwhile, its willingness to eliminate this contingency could make it appear more competitive than other bidders. The EC also could use its project subcontract as collateral to obtain a bank loan or a loan from a distributor or manufacturer. A loan like this should preserve the EC’s cash on hand and line of credit if the timing of the loan-draws and payments are tied to material and equipment deliveries and project progress payments, respectively. Any interest expense incurred as a result of a short-term collateralized loan such as this should be small in comparison to the EC’s cost of capital.

Another key element to this strategy is negotiating a delivery schedule with suppliers that minimizes storage charges. There is no advantage for the EC to store the materials and equipment or to move them several times prior to installation. It would be more efficient for the EC if distributors and manufacturers delivered materials and equipment directly to the job site when needed. In exchange for the just-in-time delivery of needed materials and equipment, distributors and manufacturers have the benefit of being paid upfront and the flexibility of producing or stocking the needed material and equipment when it is advantageous for them.

As business picks up in the coming years, the EC should consider implementing some strategies for dealing with material price escalations.